Rational Addiction, Peer Externalities and Long Run Effects of Public Policy

47 Pages Posted: 4 Oct 2002

See all articles by Donald Kenkel

Donald Kenkel

Cornell University - Department of Policy Analysis & Management (PAM); National Bureau of Economic Research (NBER)

Robert R. Reed III

University of Kentucky - Gatton College of Business and Economics

Ping Wang

Washington University in St. Louis - Department of Economics; National Bureau of Economic Research (NBER)

Date Written: October 2002

Abstract

The main purpose of this research is to understand the patterns of consumption of addictive goods, their economic and welfare consequences for society and the long-run effect of tax policy in a dynamic general equilibrium model of rational addiction. In contrast to prior research, we allow individuals to make their consumption decisions simultaneous with savings and labor supply. When addictive goods have a stronger habit formation effect (an addiction effect'), individuals choose to save less due to the anticipated adverse health consequences of addiction (a detrimental health effect'). This is particularly important since total savings pins down future productivity in the economy. We also consider the role of peer influence in the choice of addiction and find that more peer pressure' raises addictive consumption, lowers savings and reduces productivity. In light of the various distortions associated with addiction, we conclude by studying the long-run effects of an excise tax on addictive goods. Our calibration exercises suggest that incorporating capital formation and peer effects in a model of rational addiction are crucial for the design of public policy. In particular, accounting for peer externalities increases the optimal sin tax rate by more than 50 percent.

Suggested Citation

Kenkel, Donald and Reed, Robert and Wang, Ping, Rational Addiction, Peer Externalities and Long Run Effects of Public Policy (October 2002). NBER Working Paper No. w9249. Available at SSRN: https://ssrn.com/abstract=336365

Donald Kenkel

Cornell University - Department of Policy Analysis & Management (PAM) ( email )

120 Martha Van Rensselaer Hall
Ithaca, NY 14853
United States
607-255-2594 (Phone)
607-255-4071 (Fax)

National Bureau of Economic Research (NBER)

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Cambridge, MA 02138
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Robert Reed

University of Kentucky - Gatton College of Business and Economics ( email )

Department of Economics
Lexington, KY 40506
United States

Ping Wang (Contact Author)

Washington University in St. Louis - Department of Economics ( email )

One Brookings Drive
St. Louis, MO 63130
United States

National Bureau of Economic Research (NBER) ( email )

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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